Will The Real Currency Manipulator Please Stand Up?

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Includes: CHFS-OLD, UDN, USDU, UUP
by: JP Research

Summary

The art of "currency manipulation" has been mainstream for a while now.

But China isn't the real currency manipulator - despite what Trump would have you believe.

The Swiss are the biggest culprits on the surface.

But using a one size fits all approach can be misleading.

A near term SNB-driven CHF rally is on the cards.

"Just because something isn't a lie does not mean that it isn't deceptive. A liar knows that he is a liar, but one who speaks mere portions of truth in order to deceive is a craftsman of destruction."

It's hard to believe that 15 years have passed since George Soros broke the British Pound. Now, Soros has made many, many legendary trades in the past but this one in particular, stands out as the stuff of hedge fund legend. Not because he pocketed a billion dollars, although that was pretty cool. It was legendary because he battled the monetary institution of Great Britain and won.

The story tracks back to 1990 when Britain decided to enter the ERM, effectively fixing its currency at a set exchange rate to the deutschmark. The Bank of England consistently maintained this exchange rate for two years through interventions in the form of currency purchases. But as we all know from '08, it only takes one shock to dislodge the status quo. When the shock finally hit, Soros was there to capitalize. It didn't matter that BoE dealers "bought more sterling in four hours that day than anybody had before or since" or that the governors did all they could "to maintain the fiction that the pound was properly priced". If you don't get macro, macro gets you.

One of the key drivers of macro events in recent weeks has been Trump's presidential campaign lean toward anti-globalization, protectionist type policies. On several occasions, Trump has said that he would direct the Treasury Secretary to label China as a "currency manipulator" on his first day of office. Now that he has taken charge, he certainly hasn't let up. Not content with mere labeling, Mr. Trump has also made clear his intention to simultaneously direct the Secretary of Commerce and the US Trade Representative to bring trade cases against China's export subsidies at the WTO.

But what does the term "currency manipulator" mean anyway and does China actually deserve all that heat? According to the Treasury, there is a three strike rule to determining a currency manipulator - 1) FX purchases/ intervention >2% of GDP a year to cap their exchange rates, 2) current account surpluses of at least 3% of GDP and 3) a >$20bn bilateral surplus against the US.

Surprisingly enough, China does not actually fit the bill. According to the US Treasury's October 2016 Report, China met only one of the three criteria - a large bilateral trade surplus with the US. China did not qualify for the second - a material current account surplus (>3% of GDP) - and most definitely did not meet the third - persistent net purchases of foreign currency (>2% of GDP worth, over a year).

Retroactively though, Trump may have a case as China would have satisfied all three criteria for most of the 2004-10 period. The 2015 Act does not however, apply retrospectively and so, Trump will have to be a little creative if he wants to impose retaliatory measures on the grounds of currency manipulation.

Does Trump have the ability to impose sanctions against China then? The answer is yes. For quick action, Trump would only need to turn to Section 122 of the Trade Act of 1974 on the grounds that "trade with China has resulted in a large and serious US balance of payments deficit". Alternatively, he could also use Section 301 of the Trade Act of 1974 to show that China "has carried out practices that are unjustifiable and unreasonable, for example, 'currency manipulation', export subsidies and market access barriers". Even if his claims fail to hold much water, he will at least have the benefit of some statistics - China has been the single largest source of the US goods trade deficit since 2000, according to the UN.

But the real currency manipulator - going by the Treasury's definition - could actually be Switzerland. Recall the three criteria needed to define a currency manipulator - 1) intervention >2% of GDP a year to cap their exchange rates, 2) current account surpluses of at least 3% of GDP and 3)a >$20bn goods trade surplus against the US. Switzerland fits the bill on two counts while China, everybody's favorite scapegoat, only hits the mark on one point. Switzerland is for instance, the only country that scores on the intervention scale, with a whopping 9% of GDP a year utilized to cap exchange rates. Switzerland also happens to run a 10% surplus (vs. the 3% threshold) but falls short with regard to its trade surplus with the US at $13b (vs. the $20b requirement). The Swiss are however, set to be the first country to tick all three boxes if their surplus continues to expand at the same clip.

But are the Swiss really currency manipulators? I think not. Firstly, the nature of Switzerland's current account dynamics needs to be recognized. For instance, non-traditional factors (e.g. merchanting, commodity trading, financial and insurance services)play a larger role in the Swiss economy. As a result, the Swiss current account surplus is large at ~10% of GDP. A breakdown of the surplus components show a larger surplus in goods followed by sizable surpluses in income and services.

Now we get to a highly subjective but nonetheless important question - how do we objectively compare the Swiss current account position vis a vis other countries? There are some key components to review - merchanting (profit on goods bought and sold offshore by Swiss merchanting firms) and non-monetary gold should be excluded while financial services related income should be included. Taking these considerations into account should narrow the surplus significantly, disproving the notion that the CHF is undervalued. On a PPP basis, it turns out the CHF is actually overvalued by almost 20%.

This leads us to two key points - 1) One cannot meaningfully define a "currency manipulator" using the one size fits all approach that the US Treasury has implemented and 2) The likelihood of "currency manipulators" getting sanctioned is asymmetric i.e. the Chinese are far more likely to be taken to task than the Swiss.

On that note, I still suspect we will see a near term SNB-driven CHF rally as the (LOW) risk of being termed a manipulator could curb the SNB's appetite for FX purchases. In the long run though, the CHF has the potential to depreciate further relative to the USD as the currency remains cheap on PPP basis.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.